While securitization has dramatically altered the way many lenders do business, small business lending has barely changed

... Many hurdles need to be overcome before commercial loan
securitization becomes commonplace ... [but] it is by no means
difficult to envision that a couple of decades from now, markets
for business loan securities will be a reality ... Only those
bankers willing to embrace the technological change will share
in the benefits.

Federal Reserve Board of Governors
Chairman Alan Greenspan
Speech before the American Bankers
Association, October 1994

In "Casablanca," Capt. Renault orders his men to "round up the
usual suspects" in an attempt to solve a murder. Policymakers took
a similar tact in trying to identify the causes of the "credit crunch"
in the early 1990s. Bank regulators were excoriated for being overzealous
and examining institutions so aggressively that they limited credit
availability. At the same time, bankers were accused of using local
deposits to purchase Treasury securities instead of making loans.

While searching for the impetus for lower levels of bank lending,
many policymakers focused on the plight of small businesses. After
all, the perception of many elected officials and the public was
that a credit crunch was curtailing economic growth by threatening
the vitality of entrepreneurs and small businesses. This focus led
many policymakers, supported by some financial institutions and
small businesses, to insert an unexpected cause into the lineup
of the usual suspects: the absence of a market for securitized small
business loans.

Securitization is the process of repackaging loans and selling
certificates, or securities, which entitle the owner to some or
all of the repayments on the loans. More precisely, the loans are
pooled and the cash flows from the loans in the pool pay off the
interest and principal on the securities (see Diagram
1). This financial innovation has caused a revolutionary change
in lending over the last 20 years in mortgage and consumer lending
by allowing lenders to sell loans that they had previously held
to maturity.

One- to four-family mortgages were the first loans securitized,
in 1970, and there are currently over $1.7 trillion in securitized
one- to four-family mortgages outstanding. Securitization markets
grew to include non-mortgage assets in the mid-1980s, including
auto loans (1985) and credit card receivables (1986). In 1994, about
$31 billion in securities backed by credit card debt and $18 billion
in debt backed by auto loans was sold. An even wider variety of
assets has now been securitized, including boat loans, student loans
and even delinquent property tax receivables.

This profound change in banking, however, has not extended to
small business loans where securitization activity is extremely
limited, involving about one-half of 1 percent of small business
loans.

Why a market in small business loan securitization has been slow to develop

The rapid increase in the securitization of non-mortgage loans has
been driven by market forces. More specifically, the explosion in
securitization is partly due to the many benefits it produces for
borrowers, investors and lenders and partly due to technological
innovations that lowered the costs of securitizing loans. However,
despite all of the potential advantages, small business loans have
been resistant to securitization. Although exact numbers are not
available, it appears that less than $900 million in small business
loans have ever been securitized, while an estimated $155 billion
in such loans were outstanding at year-end 1994.

Why have small business loans been absent from the list of securitized
assets when securitizations of non-mortgage loans have spread so
rapidly? A favorable relationship between market benefits and costs
is responsible for the growth of non-mortgage securitization. As
such, the lack of small business loan securitizations means that
either the benefits of small business securitizations are less significant
than those of other non-mortgage loans, or the costs associated
with securitization remain comparatively high for these types of
loans, or both.

The benefits of small business loan securitizations are similar
to those of other assets. Former Federal Reserve Governor John LaWare
testified before Congress that the securitization of small business
loans could increase credit to small businesses, provide liquidity,
fee income and asset diversification for banks and reduce their
capital requirements, and offer investors a low-risk security with
attractive returns.

In fact, the primary retardant to growth seems to be cost. Determining
the expected cash flows from a pool of small business loans remains
comparatively costly. These costs are driven by three factors:

The need for specific borrower and local condition information.
To make a reasonable decision on repayment prospects, investors
need to acquire detailed information on the management quality
of a small firm and on the local economy.

The lack of standardization of loan terms. A pool of small business
loans will be very diverse in terms of: the borrowers' line of
business, the terms of the loan (for example, maturities, pricing,
covenants and collateral) the loan documentation, underwriting
standards and credit quality.

The lack of long-term performance data. Unlike the home mortgage
market, long-term data on the loan performance of small business
loans rarely is available.

This lack of data, along with a lack of loan standardization,
prevents the use of low-cost statistical methods to determine the
expected performance of the pool and substantially raises the costs
of the transactions. As a result, investors cannot be confident
about their estimates of cash flow from the pool and must expend
considerable resources in the analysis of the pools. Given other
investing options, investors have been reluctant to take on the
risk and cost of investing in small business loan pools.

Because of their reluctance take on the cost and risk of the securities,
investors would demand that the seller offer protection from losses.
This protection could be structured so that the seller either compensates
the investor directly for losses or purchases a guaranty from a
third-party financial institution for this purpose. These forms
of loss protection eliminate the need for the investor to employ
the resources to determine the risks of the loans. In addition,
investors want lenders to directly bear losses from the pool to
provide the lender with incentives to put high-quality loans in
the pool. A lender originating and selling loans, rather than holding
the loans to maturity, would not have cause to be as diligent as
normal in assessing the credit quality of the loans.

Although loss protection assuages investors, it negates benefits
that could accrue to the seller of the loans. For example, loss
protection purchased from a third party will be very expensive for
the lender as the guarantor has to recoup the costs of determining
the assumed risk. Under bank regulatory rules, when the lender continues
to bear the risk of losses from the loans, it is deemed not to have
sold the loans. As a result, the benefit of lower capital costs
cannot be achieved by banks that sell loans with a high level of
loss protection. Moreover, by retaining most of the credit risk
through the loss protection, the bank cannot use securitization
of small business loans to reduce its overall exposure to losses.
High loss protection requirements, as a result, eliminate much of
the incentive for lenders to securitize their loans.

Bankers sometimes suggest they do not securitize small business
loans because they make more money by holding these loans than by
selling them. Initially, this sounds like a different explanation
for the lack of market activity. However, the reason why banks earn
such high returns on these loans is because of the disadvantages
to securitization, specifically these loans are risky, information
intensive and less subject to non-local competition. The higher
returns merely compensate the banks for holding these relatively
risky illiquid assets.

Steps to increase the market for small business
loan securitization

The lack of small business loan securitizations is a rational outcome
of market participants weighing high informational costs relative
to transaction benefits. Nonetheless, policymakers have offered
several plans to "jump-start" this market. One recently enacted
law would reform current regulatory policy. Another plan would make
better use of existing information that the government collects
on small business loans. Neither plan is likely to lead to significant
growth of this market. Bigger increases in small business loan securitization
could be achieved by using public resources to absorb the costs
of these transactions. However, such government intervention would
not improve the use of society's resources. In contrast, market
actors are developing initiatives that could build the infrastructure
and lay the groundwork for efficient and sustainable growth of this
market. Two such efforts, described later, are taking place in the
Ninth District.

Public-sector efforts to increase the number of
small business loan securitizations

Because small businesses are considered an important source of economic
output, the Congress has historically taken actions to increase
the flow of credit to these entities. In this vein, President Clinton
signed legislation in September 1994, which, in part, sought to
increase the amount of credit flowing to small businesses by encouraging
the growth of small business loan securitization. The Riegle Community
Development and Regulatory Improvement Act of 1994 took two steps
to achieve this goal: It granted favorable regulatory treatment
to securitized small business loans (for example, it waived some
restrictions on investing securitized loans), and it made changes
in capital requirements to reduce the capital that banks selling
small business loans have to hold.

This legislation recognized that high transaction costs were the
primary cause of limited small business loan securitization. Indeed,
the legislation could lead to more small business loan securitizations
by reducing regulatory costs. However, the legislation does not
reduce the far more significant informational costs associated with
purchasing securitized loans. Thus, it is unlikely to lead to major
volume increases in this market.

The government has other means of reducing the costs of these
transactions. One proposed means of achieving this goal is the creation
of a federally chartered, but privately owned corporation that would
guarantee payment on securities backed by small business loans.
Like other government-sponsored enterprises, such as Federal National
Mortgage Association (known as Fannie Mae) or Federal Home Loan
Mortgage Corp. (Freddie Mac), the corporation would have the implied
financial support of the federal government. As a result, its guarantee
would almost eliminate default risk on small business loan securities.
Investors would no longer need to use resources to analyze the loan
pools, and loan sellers would no longer need to provide loss protection.

The risks associated with these transactions would not have been
reduced, however, but would be transferred to federal taxpayers
who support the corporation's guarantee. Such a shift could benefit
society if the corporation were able to more efficiently judge and
bear the risks posed by the loan pools. But, the corporation would
have no competitive advantage in these regards and moreover, as
a pseudo-public entity, would have less incentive than private parties
to diligently monitor potential costs. In addition, the creation
of this corporation, with its federal support, could greatly curtail
private innovation in this market.

To reduce information costs, federal agencies that already interact
with small business loans or lenders could allow market participants
to better exploit their contacts or data. For example, the Small
Business Administration (SBA) could make more widely available its
historical records on the loan repayment experience of SBA-guaranteed
loans. In a slightly different tact, the Office of the Comptroller
of the Currency (OCC) has proposed a program in which banks could
request an OCC summary of how a bank's evaluation of credit correlates
with the OCC's credit grading of the same loans. The OCC would then
produce an "agreement table." The requesting
bank can then pass out the agreement tables to investors to help
them translate issuing bank credit terms into more familiar terms.

These programs have the advantage of adding few new costs as the
agencies would already perform these functions. Both programs would
also directly address informational concerns. Yet, if enacted, these
plans are unlikely to greatly increase the number of small business
loan securitizations. The SBA data may not be relevant for investors
in evaluating loans that are not underwritten to SBA standards.
The OCC would not be able to provide historical loss information
for its loan classification system. Thus, investors will not be
able to use these classifications to determine expected payouts
from a pool of loans.

Ninth District activity related to small business loan securitization

No banks in the Ninth District have securitized small business loans
nor have disclosed plans to do so. However, the largest banking
organizations in the district, Minneapolis-based Norwest and First
Bank System (FBS), are taking steps that could make such securitizations
more likely in the future. These types of activities governed by
private measurements of costs and benefits will ultimately lead
to the expansion of the small business loan securitization market.
The Ninth District is also home to an unusual program for purchasing
and pooling commercial loans made by non-profits and local governments.

As noted above, lack of loan standardization is a major stumbling
block for small business loan securitization. Internal loan standardization
has become increasingly common among the largest banking organizations
over the last five to 10 years. FBS has established three regional
loan centers that are responsible for almost all aspects of their
small business lending, including underwriting, documenting and
servicing the loans. Because these functions have been centralized,
FBS small business loan products are more standardized in terms
of underwriting, terms and documentation. Moreover, this system
allows FBS to better monitor the performance of their loan portfolio.

While the process undertaken by FBS is primarily driven by credit
quality and cost concerns, the loan centers could have important
implications for small business loan securitization. The more standard
the small business loans of a banking organization and the better
information available on their performance, the lower the cost of
securitizing the loans. While FBS has not announced plans to securitize
small business loans, and may never do so, it now has greater ability
to undertake such a transaction.

A slightly different aspect of building the skill base for future
securitization involves reducing the cost of analyzing loan purchases
and making it more simple to purchase a diversified pool of loans.
Here, Norwest is implementing a program called "Norwest Loan Partners,"
which uses existing skills to buy and pool loans.

In the Loan Partners program, Norwest purchases loans between
$1 million and $10 million from a pre-selected group of banks. Norwest
believes banks will sell the pool loans that would otherwise leave
the banks exposed to the risk of loan concentration with one borrower
or in a geographic region. Norwest will pool these loans with the
intent of selling banks that originated the loans the right to receive
the cash flows generated by the pool. The pool will be diversified
by borrower type and geography.

If this program is successful it will allow a bank to sell off
loans that pose concentration risks and to replace their income
with cash flows from well-diversified loans, thus achieving a major
benefit of small business loan securitization. The program, however,
has grown slower than anticipated with fewer banks selling loans
to be pooled. Although the Norwest program would not constitute
full-fledged small business loan securitization, the experience
gained from the program could make the sales of securities backed
by these pools a more viable option in the future.

Outcomes from increased small business loan securitization

Given a long enough time horizon, small business securitization
will be a much more common transaction. As Fed Chairman Greenspan
noted in his speech to the American Bankers Association in 1994,
the substantial benefits of securitization provide ample incentive
for market participants to develop means to reduce the information
costs of assessing a pool of these loans. In particular, the advantage
of holding a security backed by a well-diversified pool of loans
instead of a single loan should spur cost reductions. Moreover,
competitors to banks that already fund their activities by issuing
securities have a natural incentive to find new sources of funding
and are likely to lead the development of this market. Market experience
with other assets that were once considered hard to securitize (for
example, credit card receivables) suggests that these hurdles can
be overcome.

It seems certain that small business loan securitization will
grow in the long run. But it is less clear that this form of financing
will be as dominant in the small business loan sector as it is or
will be in other loan sectors. Furthermore, while the growth of
small business loan securitization should indicate the reduction
of transaction costs, a higher volume of such securitizations will
not produce net benefits for some banks or borrowers. For example,
the increase in these transactions may not lead to additional credit
to small businesses and may actually increase costs for some small
businesses. The effect of this trend on bank profitability will
also vary a great deal.

Small business loan securitization may never be dominant

The key to increased small business loan securitization is increasing
standardization, which would bring down the costs of analyzing these
loan pools. But, there are some attributes of small business operations
and banking relationships that may inhibit standardization or low-cost
analysis over the long term. Many small businesses and banks will
resist standardization because the credit needs of small businesses
vary more than most other borrowers and bank underwriting criteria
for small business are, as a result, quite heterogeneous. Some small
business borrowers may prefer, and in some circumstances need, lenders
that are willing to maintain ownership of the loan and engage in
frequent loan restructuring.

The loans of small business borrowers who are larger and have
established predictable performance or that require less personalized
structures will be the first to be securitized with other borrowers
seeking out lenders who will not sell off their loans. By definition,
many small businesses will fall into the second camp.

Small business loan securitization and the
cost and availability of credit

Standardization of all business loans could limit small business
access to credit. Former Fed Governor LaWare noted, "Standardization
... would introduce an element of inflexibility into small business
lending and could preclude many small business firms from obtaining
the credit accommodation they need because they do not fit the 'mold'
..." He also testified that securitization increases the need for
documentation that could increase costs to small firm borrowers.
As small business loan securitization becomes more prevalent, borrowers
that do not want their loans sold off may also have to pay banks
a premium to continue to hold illiquid assets.

Small business securitization and bank profitability

Securitization will allow lenders that are particularly efficient
at one or more aspects of lending to generate fee income from securitization
that matches or exceeds the revenue they generate from holding small
business loans. For example, community banks may continue to have
an advantage in originating and servicing loans to local, smaller
firms because of their knowledge of local conditions, and of firms'
specific characteristics, like quality of management. These banks
could compete with non-bank lenders and they could continue to profit
even if they sell their loans. Securitization could also allow community
banks to originate loans, such as longer- term loans, that they
would not make if they were not able to sell.

However, other banks' profitability could be hurt by the rise
of small business loan securitization. For example, banks would
find new competition to originate loans from non-bank competitors.
Not only could banks originate and service fewer loans due to competition,
but with information easier to process, the loans in which they
are involved may produce less revenue. With a more standardized
loan product, some banks could no longer have comparative advantages
in making loans to small firms.

In the end, the market for securitizing small business loans will
certainly grow over the next few decades without additional government
assistance, as market participants lower transaction costs while
exploiting benefits. The effect of this growth, though, will not
be uniform or be viewed as an "improvement" for all small business
borrowers or lenders.

How some small business loans have been securitized

Almost all the small business loans that have been securitized to date
have been the unguaranteed part of loans partially guaranteed by the
Small Business Administration. The biggest issuer of such securities
is a subsidiary of The Money Store Inc., which has securitized about
$380 billion in unguaranteed portions of SBA 7(a) loans. Much smaller
issuers of such securities backed by the unguaranteed portion of SBA
loans include First Western of Dallas; Emergent Business Capital of
Greenville, S.C.; Zions First National Bank, Salt Lake City; and the
Colorado Housing and Finance Agency. In contrast, Fremont Financial
Corp., an asset-backed lender headquartered in Santa Monica, Calif.,
has securitized $330 million of its revolving commercial loans secured
by assets such as account receivables, inventory and machinery.

These transactions prove that small business loan securitization
is possible. But, the lenders and loans involved in these transactions
have characteristics that eased the securitization process and may
set them apart from other small business lenders and loans. For
example, these lenders are perceived to have particularly clear
and rigorous underwriting standards that are consistently applied.
More generally, the SBA nature of most of the loans leads to fairly
high loan standardization. In the same vein, the loans in these
transactions were usually supported by similar types of collateral
and documentation. In addition, the lenders were able to provide
data on their loss experience with these types of loans. Finally,
many of these issuers were very high volume lenders ensuring that
they have enough loans to make securitization, which has high fixed
expenses, cost effective. As such, these lenders were able to overcome
many of the factors described in this article that limit the growth
of this market. Even with these favorable characteristics, the lenders
had to provide loss protection ranging from 20 percent to 11 percent
of the loan pools, or purchase private bond insurance, to make the
transactions acceptable to buyers.

Why asset-backed securitization has grown

Benefits for borrowers. Securitization allows lenders to routinely
sell loans for cash. As a result, it allows lenders to make new loans
and permits borrowers to indirectly tap new sources of funds. Thus,
investors, like insurance companies and pension plans, which have only
limited direct access to home and car buyers can provide additional
funds to these classes of borrowers. The competition provided by these
new buyers to purchase loans can also lower the cost of borrowing.

Benefits for investors. Securitization produces a new low
risk debt instrument that can better match investors' maturity or
risk/return demands without investors needing to acquire the skills
necessary to make the loans themselves. Purchasing securities backed
by loans also allows investors to diversify their investments.

Benefits for Lenders. Securitization can reduce various
risks of the direct lenders. Lenders can sell their loans in securitized
form and buy the loans of others also packaged as securities. This
can provide geographic diversity and reduce business-line concentrations
in loan portfolios and eliminate the need for lenders to hold loans
to a single borrower. In addition, selling loans can reduce the
risk that banks bear when interest rates change the value of the
loans they are holding.

Securitization can also lead to cost reductions. For example,
depository institutions that sell loans no longer have to meet "capital
requirements" on the loans sold. This capital absorbs losses the
bank incurs when assets fail to perform in accordance with their
terms. Regulatory guidelines call for depository institutions to
have capital protection of up to 8 percent of the amount of small
business loans they hold. Lower capital holdings reduce regulatory
expenses for depository institutions.

Finally, lenders can generate income from securitization by charging
fees for originating loans, documenting the transaction or collecting
payments. By dividing the lending process into its discrete parts,
securitization allows lenders to focus on the aspect of lending
they do best, making the lending process more efficient.

Lower costs. The costs of securitization have fallen with
improvements in technology for producing and analyzing information.
Investors who want to purchase loans, either as securities or as
whole loans, need to understand the cash flows generated by the
loans. They must estimate the probability that loans in the pool
will default and understand the prepayment patterns of loans. When
each investor had to analyze each loan in the pool and then manually
aggregate the results, the costs of investing in securitized loans
was prohibitive. But, the combination of computing power and statistical
techniques have automated the analysis of pool cash flows, driving
down the costs of securitization and making these transactions more
feasible.

Pooling Commercial Loans Made by
Non-profits and Local Governments

Since 1989, the non-profit Community Reinvestment Fund (CRF) has purchased
"development loans" from non-profits and governmental agencies, often
at a sizable discount. According to CRF, these loans support activities
such as job creation or housing improvement. After purchasing the loans,
CRF issues bonds whose interest and principal are serviced by the loan
repayments, loan collateral and if need be a "credit reserve."

The credit reserve, along with overcollateralization, acts as the primary
loss protection for the investors and generally equals 20 percent of the
loans. The funds to finance the credit reserve have come from foundations
and the state of Minnesota, among other sources. Banks have been a major
purchaser of CRF-issued bonds in order to demonstrate community lending
for purposes of the Community Reinvestment Act. In total, CRF has purchased
$11 million in loans.